What is Liquidity?
Liquidity refers to the ease with which an asset can be exchanged for cash without affecting its price. With regards to crypto exchanges, both aspects - ease and cost- are important parts of liquidity. A trader needs their transactions completed as quickly and cost-effectively as possible in a liquid market to make a profit from it. Beyond this, we also talk about market liquidity, which deals with how well assets can be easily bought or sold at stable prices in markets such as real estate or cryptocurrency exchanges. In general terms, a liquid market offers accessible trade opportunities at transparent prices.
What does Liquidity mean for Crypto?
When it comes to the cryptocurrency market, there are three levels of liquidity that can be considered: asset liquidity, exchange liquidity and Market Liquidity. Asset liquidity is related to the buyers and sellers for a specific asset; exchange liquidity is related to how many makers or takers exist on an individual platform where traders execute trades in all sorts of different currency pairs. Market liquidity considers all these pieces together when determining if this type of trading environment has enough activity so transactions can happen at any time without too much slippage or high volatility along with other factors like fundamental analysis among other things. For this reason, it's important for frequent traders in particular who have to buy/sell strategies based on their decisions about how liquid an asset is as well as where they're executing those transactions that are made because of the said decision-making process which should also take into account whether exchanges have sufficient volume over given periods throughout the day due to fluctuations in price while taking both types into consideration.
Why is liquidity in crypto important?
The frequency of discussions over liquidity indicates its importance to the financial markets. The definition is a great place to start understanding what it means: how easy it is for you to exchange an asset without affecting its price.
Steadiness
The more liquid a market or asset, the more stable it is. When buying or selling Bitcoin, there are always traders on the other side willing to fill your order with minimal impact on its price. A less liquid and obscure altcoin will be significantly impacted by any trades executed; you'll likely have to make your way through the order book which increases bid-ask spreads and raises or lowers its overall value over time. This leaves both parties involved experiencing high slippage as well as an increase in volatility for that particular asset over time. More liquidity means stability not only for individual trades but also for that market/asset across all periods of time.
Resistance to manipulations
The crypto space has a history of price manipulation. With pseudonymous players from all over the world and little regulation, these markets are wide open for any market manipulation you can think of. But liquidity is also an issue when it comes to minimizing or preventing our markets from being manipulated. A less liquid market means that it is easier for one large actor or group to manipulate prices in their favour while more liquid assets and exchanges are much more resistant to this type of thing happening to them.
Transactions speed
Higher liquidity environments are more favourable to traders in terms of faster order execution. This also has advantages for high-frequency traders with the ability to quickly enter and exit positions in times of volatility.
Technical analysis
When it comes to trading crypto assets, many people employ the strategy of technical analysis. For those that use this technique, higher liquidity markets can increase accuracy for trades. With tighter spreads and greater stability in these environments, price and chart formations are more developed and precise than they would be in lower liquidity environments where large trades could drastically affect the shape of a chart pattern because there is less volume of activity happening at any given time.
How to measure liquidity on CEX (centralized exchanges)?
When you're trying to understand the liquidity of a specific asset, it can be helpful to look at numbers such as 24-hour trade volume on sites like CoinMarketCap. However, this data is limited and not representative of what's happening behind closed doors.
In order to measure the liquidity of a specific exchange, you need to start from the beginning - with its trading volume. Not all exchanges have an equal trade volume, so this is important. When evaluating an exchange for liquidity, one can look at its 24-hour trading volume or depth (the number of open buy and sell orders), as well as the bid-ask spread. Order book depth isn't always accurate reflections though because stop limit orders and iceberg orders are not visible to everyone on every account which could misrepresent its accuracy sometimes.
How to measure liquidity on DEX (decentralized exchanges)?
When it comes to measuring the liquidity of tokens that trade on some DEX such as Uniswap or Pancakeswap, it is much easier to do. The decentralized exchange works differently than centralized and doesn't have an orders book. All transactions and swaps make directly between sellers and buyers. So, basically, there is no way to evaluate the demand and supply for trades. And that's why so-called liquidity pools exist that solve that issue. We would discuss how liquidity pools work in our next articles but you should just keep in mind that the liquidity providers ensure with their assets the liquidity to tokens and coins that trade on DEX and the easiest way to know the amount of current liquidity is to use the TokenSpector smart contract scanner or some other chart tools.
What are the possible risks and opportunities associated with low liquidity?
We’ve spoken at length about the risks of higher liquidity, but let's be clear on some of the risks associated with low liquidity. One risk is slippage, which happens when prices are volatile and there are few participants in an asset. This can also lead to price manipulation or a long waiting time- especially during market swings - for traders who want to get involved in trades quickly. Low liquidity can have its benefits too- these include taking advantage of opportunities that arise from dips in prices due to lack of interest by others into this type of trade (such as 'flash crashes'). Additionally, arbitrage opportunities often present themselves where high orders depress the price because there aren't enough people trading that particular asset; these represent great buys for savvy traders!
In conclusion, liquidity is a measure of how much you can sell or buy at any one time without affecting the market price. It dictates things like the availability and cost of trading different currencies and assets on a given exchange. In order to have an effective strategy, it’s important to understand exactly how this impacts your trading as well as intentionally choosing exchanges with appropriate levels of liquidity for those specific assets.